Advocacy for decentralization has grown in Mexico at a rapid pace during the last decade. The gains of decentralization, however, are rather unclear and many times the assumptions and the outcomes of the process depart from the standard theory of fiscal federalism. There are serious drawbacks that should be considered before fully endorsing any decentralization program. As decentralization has progressed in Mexico, for instance, it has become evident that most of Mexican states have incurred in large fiscal deficits, majorly due to excessive overspending. This paper explains the reasons why such a trend has been observed in recent years based on a simultaneous equation model of state revenues and expenditures. The results suggest that increases in fiscal deficits are significantly associated with more intense political competition at the subnational sphere, the stage of the political business cycle, and fiscal perversity caused by political decentralization. This implies that regions expect to be bailed out by the federal government in case of financial trouble and thus do not have an incentive to observe fiscal discipline.

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